The Way of the Dollar

previous swing; and almost equally invariably you will be part of this consensus. You really know you have a consensus out there if you’re part of it.

Think back to late-1987/ early-1988, when the dollar was bottoming out after its huge decline from 1985 – if you were following currency markets then. And think back to mid-1989 when the dollar’s 18 -month rally came to an end and its downtrend resumed again.

These were the critical moments in the currency markets of the past. They were moments with recognisable characteristics. There was something wrong with the trend. The consensus was too obvious and too stale. It was suspect. We saw a consensus that was no longer being confirmed by the price-trend. Currency Bulletin has often suggested it helps to look at what we call the conversion flow* . This is the flow of conversion among currency participants from bullish to bearish sentiment and back again –which runs over many months and maybe years, underlying the big price swings. Early 1988 and mid-1989 were watershed moments in the conversion process.

They called for another look at the evidence, to see whether somewhere

–away out of the sunlight where everyone was looking– a new rationale was in the making which might reverse the trend. The new rationales were in fact staring us in the face in the form of a favourable(to the dollar) shift in interest rate structures in early 1988 and an unfavourable one in rnid-1989.

Catching such watersheds is what making big money in the currency markets is about. Catching them and clinging steadfastly, through the first doubt-sowing correction; and emerging from that trial with your confidence strengthened to hang on through subsequent corrections until you see the symptoms of the end of the big conversion swing and the beginning of the next big counter-swing.

To hold through a correction, you have to believe it is a correction in an ongoing trend. That’s not so easy because an adverse price movement obviously casts doubt on the validity of the trend. This is where CB’s sentiment gauges can help, by giving advance warning of a temporary change in price-trend. Forewarned is forearmed. If we are expecting a correction, our judgement as to whether the main swing, and its rationale, are intact is less likely to be jeopardised by intermediate price action.

If we diagnose a correction according to blueprint, we are faced with choices which depend on our individual, preferred time-frames. Can we live happily with a correction whose depth we cannot gauge in advance, secure in the belief that the main swing will resume? Do we prefer to cut back our exposures to core* positions or long-dated options? Or do we relish the challenge of trying to scalp profits out of corrections? To know the answers, we have to know ourselves. In particular, we have to know what risk we can handle emotionally.

CHAPTER EIGHT

“I have two basic rules about winning in trading as well as in life. (1) If you don’t bet, you can’t win. (2) If you lose all your chips, you can’t bet. “

LARRY HITE

As if it should come as a surprise, the currencies trade much like other markets. In stock markets and commodity markets, a wealth of wisdom has accumulated over the ages. We can’t recognise wisdom except from our own experience. But this body of market lore is as valuable to the currency trader as to traders in any other market.

Of my 30 years trading financial markets, two thirds was spent trading the securities markets mainly. The last 10 years have been spent trading the currency markets. As far as the practice of trading goes –as opposed to analysis or forecasting –a striking difference between currencies and securities is the difference between trading cash instruments that you pay for and forward* or future* instruments that are settled at a later date. The lack of settlement procedures and certificates; the low transaction costs; the sheer ease of entering, exiting and re- entering positions; all these things seemed to call for a different more active approach. At least that’s the way it seemed to me, and to many people.

But perhaps that’s wrong. (For purposes of simplicity, the word “future” –or “futures” –may be used to cover both forward and futures transactions in currencies ). Why should the fact that you only have to put up a relatively tiny margin to trade instruments that have to be settled at a future date –as opposed to cash –make any difference to the way one trades? Well there’s a potential trap here. The use of leverage encourages excessive positions –“overtrading”*: and the ease of trading encourages a more jumpy and emotional approach. Yet it’s interesting that the accounts of great traders don’t seem to distinguish between the two.

Well why should they? The main issue is risk, and it’s entirely up to us how much risk we take on board in our trading. Let’s recap on the checklist suggested in the last chapter. Know your reason. That’s been dealt with in chapters one to six. We have to know the reason for taking a trade so as to close it once the reason is no longer valid. Chapter 7 dealt with the time-

frame. It tried to show how important this was too. What about know yourself? Well, as we shall see in Chapter Eleven, this may be the crucial part of the checklist for many readers. But until then, let’s take another look at risk.

The neatest thing ever said about risk was the dictum of Larry Hite, a founder of the giant Mint group, which is quoted at the start of this chapter. Most of us are conditioned into thinking of risk as a bad thing: something to be avoided. The word itself has pejorative connotations. This conditioning does us no favour in financial markets. It leads us to seek situations which offer no risk, and to run away from those where the risk is most evident to us. But there are no situations which offer no risk and at the same time offer the chance of reward. And the situations where risk seems most evident are often those where it is in fact lowest.

In financial markets, risk is the possibility of financial loss or even “financial disablement” as the euphemism goes. The risk in being short is obviously at its lowest (did we but know it) when prices have risen to a peak. Yet that is when the risk of being short seems to be highest. Likewise the risk of holding is lowest when prices have fallen to a trough – which is when our perception of the risk of holding is most acute.

So before we can even hope to deal with risk in actual trading we need to reverse our conditioning and start again. Of course we don’t know when prices have reached a trough, or a peak. The solution cannot be to try and second– guess the real risk. It has to be to recognise that every position involves a risk; to recognise that our perception of risk is unreliable; and to acknowledge that the way to quantify the risk is to define it beforehand. It is as simple as that. The simplest way to define the risk is to determine a stop-limit (see page 75) and many traders like to do this with a market order. But as a first step , all of us, if we are to quantify our risk, have to determine it beforehand in actual money –dollars, pounds, DM or whatever.

Making friends with RISK

I say it’s simple – but it does involve a new mind-set for most of us, and that may need practice. The new mind-set runs as follows. As a participant in the currency markets, I am a risk-taker. I have to take risks in order to achieve reward, which is what I am trading for. So I welcome risk, as I